Inside Debt, Bank Default Risk, and Performance during the Crisis

The role of executive compensation as a possible cause of the recent financial crisis has attracted significant attention from the public, policy makers, and researchers. The Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd Frank Act), which was signed into law on July 21, 2010, requires the regulatory agencies to prohibit the incentive-based compensation practices that encourage inappropriate risk-taking activities at financial institutions.

One question that emerged from this attention and the subsequent legislative action is whether there is a relation between executive compensation and excessive risk taking at banks. An extensive body of research examines the relation between risk taking and the inside equity (stock options and firm equity) holdings of the chief executive officer (CEO). In our paper “Inside Debt, Bank Default Risk and Performance during the Crisis,” which was recently made publicly available on SSRN, rather than focus on inside equity, we instead study inside debt (pension benefits and deferred compensation). In particular, we investigate whether the bank holding companies (BHCs) that compensate their CEOs with higher inside debt relative to inside equity, the inside debt ratio, had a lower risk of default and better performance during the most recent financial crisis. Furthermore, we explore whether the inside debt ratio has more power to explain the default risk and the performance in BHCs than the measures based on inside equity.

In a sample of 371 BHCs in the U.S., we show that relative to non-financial firms, the compensation structure of an average BHC creates the incentives for the CEO that are very highly aligned with the BHC’s shareholders. Multivariate analyses indicate that a CEO’s higher inside debt ratio in 2006 has a significant association with a lower default risk at the end of 2008, after controlling for the characteristics of the BHC and the CEO. We also find that the BHCs performed significantly better during the crisis if they compensated their CEOs with more inside debt relative to inside equity in 2006. Furthermore, we show that the inside equity-based measures have explanatory power, but lose significance when the inside debt ratio is added to the same regression. These findings imply that the inside debt ratio is a critical signal for the default risk and the performance of the BHC.

In contrast to non-financial corporations, bank’s default risk is evaluated by bank supervisors, whose interests are closely aligned with the non-equity stakeholders (depositors and other debt holders). These evaluations in part reflect an ex ante assessment of BHC management quality. We examine the relation between bank supervisory ratings and the CEOs’ inside debt and test whether the inside debt is related to higher management quality as perceived by a non-equity stakeholder. We show that there is a significant association between favorable supervisory ratings and the inside debt ratio of the CEO. This finding is especially interesting because in 2006 examiners were not required to consider components of the CEO’s compensation such as inside debt and equity when determining a supervisory rating. Thus, the BHCs whose performance was deemed favorable by the supervisors also happened to be those that had a higher inside debt ratio.

The policy implications of our findings are as follows. There is an important role for the inside debt ratio as a signal of the risk-taking incentives of the banks’ executives. BHCs’ stakeholders can use this information to identify banks where the compensation structure provides the CEO with incentives that are aligned more with the debt holders and therefore inclined towards less risk taking, or more aligned with the shareholders and therefore inclined towards more risk taking.

The full paper is available for download here.